DECISION THEORY

Decision theory is both descriptive and prescriptive business knowledge and

compare expected outcomes due to several courses of action.
The degree of knowledge divided into four categories: Complete knowledge
(certainty), Risk, Uncertainty, and Ignorance.
Decision Analysis – It is an analytical approach of comparing decision
alternatives in terms of expected outcomes.
Decision alternatives – There is a finite number of decision alternatives available
to the decision maker at each point in time when a decision made.
States of nature – A state of nature is an event or scenario that is not under the
control of decision makers. For instance, it may be the state of economy
(inflation), a weather condition, a political development, etc.
Payoff – It is a numerical value (outcome) obtained due to the application of each
possible combination of decision alternatives and states of nature.
Steps of Decision-Making Process
The decision-making process involves the following steps:
1. Identify and define the problem.
2. List all possible future events (not under the control of decision maker) that
are likely to occur.
3. Identify all the courses of action available to the decision-maker.
4. Express the payoffs resulting from each combination of course of action
and state of nature.
5. Apply an appropriate decision theory model to select the best course of
action from the given list based on a criterion (measure of effectiveness) to
get optimal (desired) payoff.
Exercise: A firm manufactures three types of products. The fixed and variable
costs are given below.
Particulars Sales price PU Fixed cost (in Rs) Variable cost per unit
Product A 25 25,000 12
Product B 25 35,000 9
Product C 25 53,000 7
The likely demand (units) of the products is given below
Poor demand: 3,000 units; Moderate demand: 7,000 units; High demand: 11,000
units. Prepare the pay-off matrix.
Types of Decision-Making Environments
To arrive at an optimal decision, it is essential to have an exhaustive list of
decision alternatives, knowledge of decision environments, and use of
appropriate quantitative approach for decision making.
Decision making environments are: Certainty, Uncertainty and Risk.
Decision Making Under Certainty
In this decision-making environment, decision-maker has complete knowledge
(perfect information) of outcome due to each decision-alternative (course of
action). In such a case he would select a decision alternative that yields the
maximum return (payoff) under known state of nature.
Decision Making Under Risk
In this decision-environment, the decision-maker does not have perfect
knowledge about possible outcome of every decision alternative. It may be due
to more than one states of nature. In a such a case he assumes of the probability
of occurrence of particular state of nature.
Decision Making Under Uncertainty
In this decision-environment, decision-maker is unable to specify the probability
for occurrence of particular state of nature. However, this is not the case of
decision-making under ignorance, because the possible states of nature are
known. Thus, decision under uncertainty are taken with less information than
decisions under risk.
DECISION-MAKING UNDER CERTAINTY
When probability of any outcome cannot be quantified, the decision-maker must
arrive at a decision only on the actual conditional pay-off values, keeping in view
the criterion of effectiveness (policy). The following criteria of decision-making
under uncertainty have been discussed in this section.
i. Optimism (Maximax or Minimin) criterion
ii. Pessimism (Maximin or Minimax) criterion
iii. Equal probabilities (Laplace) criterion
iv. Coefficient of optimism (Hurwiez) criterion
v. Regret (salvage) criterion
Optimism (Maximax or Minimin) criterion: “Go for the Gold”
Select the decision that results in the maximum of the maximum rewards
• A very optimistic decision criterion
– Decision maker assumes that the most favourable state of nature for each action
will occur
• Most risk prone agent
MAXIMAX
Decision States of Nature Maximum in row
Favourable Unfavourable
Plant X 4,00,000 (3,00,000) 4,00,000
Plant Y 2,00,000 (50,000) 2,00,000
No Plant 0 0 0
Here assumes that the most favourable, state of nature occurs for each decision
alternative
• Select the maximum reward for each decision
– All three maximums occur if a favourable economy prevails (a tie in case of no
plant)
• Select the maximum of the maximums
– Maximum is Rs. 400,000; corresponding decision is to build the plant X
– Potential loss of Rs. 3,00,000 is completely ignored.
Pessimism (Maximin or Minimax) criterion - “Best of the Worst”
Select the decision that results in the maximum of the minimum rewards
• A very pessimistic decision criterion
– Decision maker assumes that the minimum reward occurs for each decision
alternative
– Select the maximum of these minimum rewards
• Most risk averse agent
MAXIMIN
Decision States of Nature Minimum in row
Favourable Unfavourable
Plant X 4,00,000 (3,00,000) (3,00,000)
Plant Y 2,00,000 (50,000) (50,000)
No Plant 0 0 0

Here assumes that the least favourable state of nature occurs for each decision
alternative
• Select the minimum reward for each decision
– All three minimums occur if an unfavourable economy prevails (a tie in case of
no plant)
• Select the maximum of the minimums
– Maximum is Rs. 0; corresponding decision is to do nothing
– A conservative decision; largest possible gain, Rs. 0, is much less than
maximax.
Equal probabilities (Laplace) criterion
Assumes that all states of nature are equally likely to occur
– Maximax criterion assumed the most favourable state of nature occurs for each
decision
– Maximin criterion assumed the least favourable state of nature occurs for each
decision
• Calculate the average reward for each alternative and select the alternative with
the maximum number
– Average reward: the sum of all rewards divided by the number of states of nature
• Select the decision that gives the highest average reward
EQUAL LIKELYHOOD (LAPLACE)
Decision States of Nature Row Average
Favourable Unfavourable
Plant X 4,00,000 (3,00,000) 50,000
Plant Y 2,00,000 (50,000) 75,000
No Plant 0 0 0
Select the decision with the highest weighted value.
4,00,000 − 3,00,000 2,00,000 − 50,000
Plant X = = 50,000; Plant Y = = 75,000
2 2

– Maximum is Rs. 75,000; corresponding decision is to build the plant Y.

Coefficient of optimism (Hurwiez) criterion
Criterion of Realism
• Also known as the weighted average or Hurwiez criterion
– A compromise between an optimistic and pessimistic decision
• A coefficient of realism, α, is selected by the decision
maker to indicate optimism or pessimism about the future 0 < α <1
When α is close to 1, the decision maker is optimistic. When α is close to 0, the
decision maker is pessimistic.
• Criterion of realism = α (row maximum) + (1- α)(row minimum)
– A weighted average where maximum and minimum rewards are weighted by α
and (1 - α) respectively
COEFFICIENT OF OPTIMISM (HURWIEZ)
Decision States of Nature Optimism
Favourable Unfavourable
Plant X 4,00,000 (3,00,000) 1,90,000
Plant Y 2,00,000 (50,000) 1,25,000
No Plant 0 0 0
(Assume a coefficient of realism equal to 0.7)
Weighted Averages
Plant X = (0.7)(4,00,000) + (0.3)(-3,00,000) = 2,80,000 – 90,000 = Rs. 1,90,000
Plant Y = (0.7)(2,00,000) + (0.3)(-50,000) = 1,40,000 – 15,000 = Rs. 1,25,000
No plant = (0.7)(0) + (0.3)(0) = 0 – 0 = Rs. 0

Select the decision with the highest weighted value

Maximum is Rs. 1,90,000; corresponding decision is to build the plant X
Regret (salvage) criterion
Regret/Opportunity Loss: “the difference between the optimal reward and the
actual reward received”
• Choose the alternative that minimizes the maximum regret associated with
each alternative
– Start by determining the maximum regret for each alternative
– Pick the alternative with the minimum number
MINIMAX REGRET
Decision States of Nature Row
Favourable Unfavourable maximum
Payoff Regret
Plant X 4,00,000 0 (3,00,000) 3,00,000 3,00,000
Plant Y 2,00,000 2,00,000 (50,000) 50,000 2,00,000
No Plant 0 4,00,000 0 0 4,00,000
Best payoff 4,00,000 0

Select the alternative with the lowest maximum regret

Minimum is Rs. 2,00,000; corresponding decision is to build a plant Y

Summary of Results
Criterion Decision
Maximax Build a plant X
Maximin Do nothing
Equal likelihood Build a plant Y
Realism Build a plant X
Minimax regret Build a plant Y
Exercise: A food products’ company is contemplating the introduction of a
revolutionary new product with new packaging or replacing the existing product
at much higher price (S1). It may even make a moderate change in the
composition of the existing product, with a new packaging at a small increase in
price (S2), or may a small change in the composition of the existing product,
backing it with word ‘New’ and a negligible increase in prices (S 3). The three
possible states of nature or events are: (i) high increase in sales N1 (ii) no change
in sales N2 and (iii) decrease in sales N3. The marketing department of the
company worked out the payoffs in terms of yearly net profits for each
department of the company worked out the payoffs in terms of yearly net profits
for each of the strategies of three events (expected sales). This is represented in
the following table:
Strategies States of Nature
N1 N2 N3
S1 7,00,000 3,00,000 1,50,000
S2 5,00,000 4,50,000 0
S3 3,00,000 3,00,000 3,00,000

Which strategy should be concerned executive choose on the basis of

a. Maximin criterion; b. Maximax criterion; c. Minimax regret; d. Laplace
criterion.
 DECISION TREE ANALYSIS
Decision-making problems discussed earlier were limited to arrive at a decision
over a fixed period of time.
“Decision tree – it is the graphical display of the progression of decision and
random events.”
A decision tree consists of nodes, branches, probability estimates, and payoffs.
There are two types of nodes
Decision (or act) node: A decision node is represented by a square and represents
a point of time where a decision-maker must select one alternative course of
action among the available. The courses of action are shown as branches or arcs
emerging out of decision node.
Chance (or event or outcome) node: Each course of action may result in a chance
node. The chance node is represented by a circle and indicates a point of time
where decision-maker will discover the response to his decision.
Branches emerge from and connect various nodes and represent either decisions
or states of nature. There are three types of branches.
Decision branch: It is the branch leading away from a decision node and
represents a course of action that can be chosen at a discount point.
Chance branch: It is the branch leading away from a chance node and represents
the state of nature of a set of chance of events. The assumed probabilities of the
states of nature are written alongside their respective chance branch.
Terminal branch: Any branch that makes the end of decision tree (not followed
by either a decision or chance node), is called a terminal branch. A terminal
branch can represent either a course of action.
Payoff can be positive (i.e., revenue or sales) or negative (i.e., expenditure, loss,
or cost) and it can be associated either with decision or chance branches.
It is possible for a decision tree to be deterministic or probabilistic. It can also
further be divided in terms of stages – into single stage (a decision under condition
of certainty) and multistage (a sequence of decisions).
Exercise 1: You are given the following estimates concerning a research
development programme.
Decision Probability of Outcome Probability of Payoff value
Decision number outcome of outcome
Develop 0.5 1 0.6 6,00,000
2 0.3 (1,00,000)
3 0.1 0
Do not 0.5 1 0.0 6,00,000
develop 2 0.0 (1,00,000)
3 1.0 0

Construct and evaluate the decision tree diagram for the above data. Show your
workings for evaluation.
Exercise 2: A glass factory that specializes in crystal is developing a substantial
backlog and for this the firm’s management is considering three courses of action:
To arrange for subcontracting (S1), to begin overtime production (S2), and to
construct new facilities (S3). The correct choice depends largely upon the future
demand, which may be low, medium, or high. By consensus, management ranks
the respective probabilities as 0.10, 0.50, and 0.40. A cost analysis reveals the
effect upon the profits. This is shown in the table below:
Demand Probability Course of Action
S1 S2 S3
Low (L) 0.10 10 -20 -150
Medium (M) 0.50 50 60 20
High (H) 0.40 50 100 200
Show this decision situation in the form of a decision tree and indicate the most
preferred decision and its corresponding expected value.

Exercise 3: A businessman has two independent investment portfolios A and B,

available to him, but he lacks the capital to undertake both of them
simultaneously. He either choose A first and then stop, or if A is successful, then
take, B or vice versa. The probability of success of A is 0.6, while for B it is 0.4.
Both investment schemes require initial capital outlay of 10,000 and both return
nothing if the venture proves to be unsuccessful. Successful completion of A will
return 20,000 (over cost) and successful completion of B will return 24,000 (over
cost). Draw a decision tree in order to determine e best strategy.

Strengths and Weakness of Decision Tree Methods

The strengths of decision tree methods are:
• Decision trees are able to generate understandable rules.
• Decision trees perform classification without requiring much computation.
• Decision trees are able to handle both continuous and categorical variables.
• Decision trees provide a clear indication of which fields are most important
for prediction or classification.
The weaknesses of decision tree methods
• Decision trees are less appropriate for estimation tasks where the goal is to
predict the value of a continuous attribute.
• Decision trees are prone to errors in classification problems with many
classes and relatively small number of training examples.
Decision Making Under Risk
In this decision-making environment, decision-maker has sufficient information
to assign probability to the likely occurrence of each outcome (state of nature).
Knowing the probability distribution of outcomes (states of nature), the decision-
maker needs to select a course of action resulting a largest expected (average)
payoff value. The expected payoff is the sum of all possible weighted payoffs
resulting from choosing a decision alternative. The widely used criterion for
evaluating decision alternatives (courses of action) under risk is the Expected
Monetary Value (EMV) or Expected Utility.

Expected Monetary Value (EMV)

Expected Monetary Value: It is obtained by adding payoffs for each course of
action, multiplied by the probabilities associated with each state of nature.
The expected monetary value (EMV) for a given course of action is obtained by
adding payoff values multiplied by the probabilities associated with each state of
nature. Mathematically, EMV is stated as follows:
EMV (Course of action, Sj)= ∑𝑛𝑖=1 𝑝𝑖𝑗 𝑝𝑖
Where m = number of possible states of nature
pi = probability of occurrence of state of nature, Ni
pij = payoff associated with state of nature Ni and course of action, Sj
Procedure
1. Construct a payoff matrix losing all possible courses of action and states of
nature Enter the conditional payoff values associated with each possible
combination of course of action and state of nature along with the probabilities
of the occurrence of each state of nature
2. Calculate the EMV for each course of action by multiplying the conditional
payoffs by the associated probabilities and adding these weighted values for each
course of action
3. Select the course of action that yields the optimal EMV.
Exercise: A retailer purchases cherries every morning at Rs.50 a case and sells
them for Rs.80 a case. Any case that remains unsold at the end of the day can be
disposed of the next day at a salvage value of Rs.20 per case (thereafter they have
no value). Past sales have ranged from 15 to 18 cases per day. The following is
the record of sales for the past 120 days.
Cases sold : 15 16 17 18
Number of days : 12 24 48 36
Find out how many cases should the retailer purchase per day in order to
maximize his profit.

Expected Opportunity Loss (EOL)

Expected opportunity loss (EOL), also called expected value of regret, is an
alternative decision criterion for decision making under risk. The EOL is defined
as the difference between the highest profit (or payoff) and the actual profit due
to choosing a particular course of action in a particular state of nature. Hence,
EOL is the amount of payoff that is lost by not choosing a course of action
resulting to the minimum payoff in a particular state of nature. A course of action
resulting to the minimum EOL is preferred. Mathematically, EOL is stated as
follows.
EOL (State of nature, Nj) = ∑𝑛𝑖=1 𝑙𝑖𝑗 𝑝𝑖
where lij = opportunity loss due to state of nature, Ni and course of action, Sj
pi = probability of occurrence of state of nature, Ni

Procedure:
1. Prepare a conditional payoff values matrix for each combination of course of
action and state of nature along with the associated probabilities.
2. For each state of nature calculate the conditional opportunity loss (COL) values
by subtracting each payoff from the maximum payoff.
3. Calculate the EOL for each course of action by multiplying the probability of
each state of nature with the COL value and then adding the values.
4. Select a course of action for which the EOL is minimum.
Exercise: A company manufactures goods for a market in which the technology
of the product is changing rapidly. The research and development department has
produced a new product that appears to have potential for commercial
exploitation. A further Rs.60,000 is required for development testing.
The company has 100 customers and each customer might purchase, at the most,
one unit of the product. Market research suggests that a selling price of Rs.6,000
for each unit, with total variable costs of manufacturing and selling estimate as
Rs.2,000 for each unit.
From previous experience, it has been possible to derive a probability distribution
relating to the proportion of customers who will buy the product as follows:
Proportion of customers : 0.04 0.08 0.12 0.16 0.20
Probability : 0.10 0.10 0.20 0.40 0.20
Determine the expected opportunity losses, given no other information than that
stated above, and state whether or not the company should develop the product.